H2 Prelims Paper 1 Suggested Answers

Anderson Serangoon Junior College 2022 JC2 H2 Economics Preliminary Examination Paper 1 Suggested answers Question 1: Retail troubles (a)(i) With reference to Figure 1: [1] Compare restaurant prices relative to grocery retail prices in the United States from 1960 to 2014. Restaurant prices increased by 350% relative to grocery retail prices. (ii) Using the concept of income elasticity of demand, account for the above observation. [2] • Restaurant food has YED > 1 whereas YED for grocery retail is 0 < YED <1 • Increase in income leads to increase in demand for restaurant food by more than proportionately as compared to retail food where demand increase by less than proportionately . Hence there is greater increase in price for restaurant food relative to grocery retail prices. (b) With reference to Extract 1: (i) Identify and explain the evidence that indicates the likely price elasticity of demand for food for households. [3] • Evidence: “increase in food and drink spending of nearly 7%” • Inference: Demand for food is price inelastic → PED <1 • This is because when price of food increase, expenditure would increase if quantity demanded falls less than proportionately. The increase in expenditure due to price increase is greater than the fall in expenditure due to the fall in quantity demanded, causing overall total expenditure to increase. (ii) Explain one unintended consequence of the proposed ‘UK government policies around public health and sustainability’. [2] • Rise in inequity → The poor spend a bigger proportion of their income on food than the rich. With rising prices and with nominal income unchanged, their real income falls. The poor are worse off compared to the rich. This then increases inequity. • Rise in debt → With rising costs due to having to comply with the new government regulations on public health and sustainability, firms will have lower profits and some may suffer losses , assuming no change in total revenue. Firms may resort to borrowing to finance their current ope rating costs. Thus, debt increased. • Loss of competitiveness → Rising costs due to the new government regulations will increase price of domestically produced food and drinks. This will reduce their price competitiveness as compared to imported food an d drinks, resulting in fall in demand for domestically produced food and drinks as consumers switched to imported goods. Domestic firms will suffer from losses and some may exit the industry resulting in increase in unemployment in the food and drinks industry. (c) Extract 2 states that low-cost supermarket chain Aldi ‘will never be beaten on price’. [4]

With the aid of a diagram, explain how the strategy of opening many more stores than Tesco enabled Aldi and Lidl to increase their price competitiveness. ‘Opening of many more stores’ represents expansion of the firm, which enables Aldi and Lidl to reap internal economies of scale (EOS) and enjoy cost advantages. Internal EOS refers to the fall in long run average cost that accrues to a firm as it increases its own output level. Some examples include marketing and technical EOS. For example, with larger scale of operation, Aldi and Lidl will be buying larger quantities of inputs compared to its competitors and so are in a stronger position to negotiate discounts from its suppliers and enjoy lower cost for their inputs . It could also enjoy technical EOS gained through specialisation of labour. “Aldi said it will hire 20,000 new members of staff to fuel its expansion”. As its scale of operation increases, it becomes more efficient to allow workers to specialise in their tasks as it saves time to repeat the same task rat her than move from one task to another. Thus more output can be produced in a given time because of the increase in workers' productivity. Division of labour thus increases the productivity of labour, resulting in lower unit cost of production. Thus because of the ability to reap larger internal EOS, the marginal and average cost of Aldi and Lidl, represented as MC2 and AC2, are significantly lower than the marginal and average cost of its competitors such as Tesco, represented as MC1 and AC1 shown in the diagram below. Assuming profit -maximisation objective, both firms would be producing at the output level where their respective marginal cost equal their respective marginal revenue. Assuming the same demand (AR), Tesco would be producing at Q1 and charging price P 1. On the other hand, Aldi and Lidl would be producing a larger quantity at Q 2 and charging lower price at P 2, thereby increasing its price competitiveness. (d) Discuss whether going digital will help firms make supernormal profits. [8] P1: Going digital can help firms make supernormal profits if it increases demand and lower costs.

Profits is the difference between total revenue and total costs. Extract 3 said that ‘online shopping will continue to accelerate’. Consumers increasingly are making their purchases online rather than buying from brick and mortar stores. Firms can increase demand for their goods due to this change in taste and preference, by also selling online to complement their brick and mortar st ores. Online shopping also expands demand for the firms’ goods as the firms can sell beyond their own locality and can even go international. Figure 1 shows a rightward shift of the AR and MR curve from AR0 to AR1. At the profit-maximizing output of Q 0, where MC=MR, the firm is making normal profits as TR is equal to TC, OP0GQ0. Assuming no change in costs, the rise in demand increases the equilibrium output to Q1 where MC cuts MR1 and the price is higher at P 1 instead of P 0. TR (OP 1AQ1) is now higher tha n TC (OPBQ 1) and the supernormal profits is area P1APB. Figure 1 In addition, going digital can also help a firm to cut costs. For brick and mortar stores, they can cut down the number of physical stores and reduce the number of employees as well as the amount of inventories. As both rent and wages take up a big proport ion of a retailing firm’s total costs, their cost savings can be significant. This will reduce both their fixed and variable costs which then shifts their AC and MC curves downwards. As seen from Figure 2, the profit-maximizing output increases from Q0 to Q1 and the firm’s TR revenue is unchanged but TC is reduced from OP0GQ0 to OPBQ. The firm is now making supernormal profits of PP1AB. G AC P0 MC AR0 MR0 0 Q0Q1 Quantity Price, Revenue, Cost AR1 MR1 P1 A B P

Figure 2 P2: However, going digital may not necessarily increase a firm’s profits. Demand may not increase, nor cost be lower. Extract 3 mentioned that only ‘ retailers with strong platforms and sophisticated data analysis have succeeded in connecting with consumers ’. Firstly, the retail sector is very much a monopolistically competitive market. There are many other sellers - some small like hair dressing but there are large sellers like Tesco. It may not be too costly for a firm to set up an online platform especially when there is a lot of information from the internet as well as many web developers offering their services online. However, only the best online platforms which have both convenience, security, and other attractive features based on their data analysis of consumer preferences that are best able to get consumers to make purchases from their online stores. It may be very costly to be able to set up an online platform that is way better than others. Likewise, demand may not increase if the platform is not user friendly, where payment security is an issue or where delivery is not prompt or charges too high. It is similar to the idea of advertising. Not every firm that advertises is boun d to be able to increase demand sig